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Accounting for Warranties Under the New Revenue Recognition Standard

Insights Accounting for Warranties Under the New Revenue Recognition Standard

Many companies provide or sell additional warranties on their products. The new revenue recognition standard, ASC 606 Revenue From Contractswith Customers, specifically addresses defining warranties within a contract and determining if they should be accounted for as a separate performance obligation.

On May 28, 2014 the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued their final standard on revenue from contracts with customers. The standard, issued as ASU 2014-09 by the FASB and as IFRS 15 by the IASB, outlines guidance for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.

The core principle of the standard is to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

The core principle is supported by the following five steps in recognizing revenue:

Identify the customer contract(s)

Identify the performance obligation(s) in the contract

Determine the transaction price

Allocate the transaction price to the performance obligation(s) in the contract

Defining Warranties: Warranties play a role in steps 2 and 3 depending on if the warranty is an assurance warranty or service warranty. Assurance warranties provide the customer with assurance that the related product will function as the parties intended because it complies with agreed-upon specifications. Service warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. Revenue recognition methods will vary depending on which type of warranty is offered.

Determining if a Warranty is a Performance Obligation: Generally, an assurance warranty would not be deemed to be a separate performance obligation, whereas a service warranty typically would be considered a performance obligation. The following are excerpts from ASC 606 clarifying general situations:

If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation.

If a warranty, or a part of a warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service is a performance obligation. If an entity promises both an assurance-type warranty and a service-type warranty but cannot reasonably account for them separately, the entity should account for both of the warranties together as a single performance obligation.

It is important to note that a warranty does not have to be sold separately or specifically negotiated to be considered a performance obligation. ASC 606-10-55-33 lays out other factors to consider when assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications:

Whether the warranty is required by law — If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.

The length of the warranty coverage period — The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.

The nature of the tasks that the entity promises to perform — If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.

Should the entity determine that there is no separate performance obligation, the warranty should be accounted for as it has been under previous guidance ASC 460 Guarantees, and it is not affected by the new revenue recognition standard. However should a separate performance obligation be determined to exist the entity would then need to allocate a portion of the transaction price to the separate service and recognize the related revenue when (or as) performance is completed. Additionally, disclosure requirements state the following qualitative information must be disclosed for nonpublic entities: when the performance obligation is typically satisfied, significant payment terms, the nature of the goods or services promised, obligations for returns or refunds, and the identification of the type of warranty and related obligations.

The effective date for all non-public entities are annual reporting periods beginning after December 15, 2018, and interim reporting periods within annual reporting periods beginning after December 15, 2019.

If you have any specific questions regarding the new guidance for revenue recognition, please contact your BlumShapiro partner for assistance or Janet Prisloe, Partner and leader of the BlumShapiro Manufacturing/Distribution Industry Group.